NEW YORK ( TheStreet) -- The rally in bonds, like the bull market in stocks, may be slowing.High-yield bond funds returned 32% in the past year, and intermediate-term bond funds gained 14%, according to Morningstar. Many bonds now have high prices and low yields, which could be reversed if interest rates rise in the next year, as many economists predict. Should you avoid bond funds altogether? Probably not. Most portfolios should have fixed income for diversification. Consider putting part of your fixed-income holdings into flexible funds. These have the ability to emphasize Treasuries one year and corporate bonds the next. By trading deftly, top flexible funds limit losses in hard times. In contrast, typical bond funds hold relatively static portfolios that can be hurt when interest rates rise. A compelling flexible choice is Delaware Diversified Income ( DPDFX), which returned 9.2% annually during the past 10 years. Of the 495 intermediate-term bond funds tracked by Morningstar, Delaware ranked as the top performer for the decade. The fund achieved its stellar record by holding a mix that included Treasuries, foreign debt, corporate issues and mortgages. By avoiding richly priced bonds, Delaware navigated through the rollercoaster markets of recent years. Before the credit crisis began in 2006, the fund had 25% of its assets in high-yield bonds, which are rated below-investment grade. But as conditions deteriorated, the fund began unloading its riskier bonds. By the end of 2007, Delaware had only 10% of assets in high yield. The fund managers steered away from junk because they worried that the market was becoming too complacent about risk. Investors were snapping up shaky issues, and junk only yielded a bit more than high-grade bonds. "A lot of the new high-yield issuance was coming from companies that had unattractive balance sheets," Delaware manager Roger Early says. The move away from junk proved well-timed, since many lower-rated issues collapsed during the downturn of 2008. Then by early 2009, Delaware began reversing course, loading up on junk bonds. At the time, many junk bonds yielded 1,500 basis points (15 percentage points) more than investment-grade debt. By the end of last year, the fund had more than 30% of its assets in high-yield bonds. The big junk position helped the fund climb as bonds rallied.
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During the credit crisis, Delaware had 20% of assets in Treasuries and government-backed agency securities, which helped cushion the portfolio. Today the figure has dropped to 3%. Manager Early says the outlook for government issues is deteriorating. "There will be a massive new supply of Treasuries this year in order to fund the deficit," he says. "Yields will need to rise in order to attract investors." Another deft fund is Janus Flexible Bond ( JAFIX), which has returned 6.8% annually during the past 10 years, outdoing 83% of intermediate funds. During 2008, the fund had 70% of assets in government-backed issues, including Treasuries and mortgages. That enabled Janus to return 5.6% for the year, outperforming its average competitor by 10 percentage points. Since then the fund has shifted away from government securities, putting 70% of assets in junk and investment-grade corporate bonds. At the height of the crisis, Janus had 40% of assets in high-quality mortgages. The issues looked attractive because they yielded 175 basis points more than Treasuries, Janus manager Gibson Smith says. Since then, the spread has narrowed to 25 basis points. Because the yields have become so slim, Janus no longer holds any mortgages, Smith says. The markets have changed because the Federal Reserve purchased $1.25 trillion of mortgages. That pushed up prices and lowered yields. The tiny yields don't compensate investors for the risks in the mortgage market, Smith says. "At some point, the Federal Reserve will have to exit the market and begin selling mortgages," he says. "When the Fed pulls away, prices could go down." Smith favors investment-grade corporate bonds, which yield 150 basis points more than Treasuries. He also owns some junk, which yields 600 basis points more than Treasuries. For a cautious flexible fund, consider Artio Total Return Bond ( BJBGX), which has returned 7% annually during the past 10 years, beating 87% of intermediate funds. While it holds a mix of government and investment-grade corporate bonds, the fund never owns junk. The high-quality holdings helped Artio stay in the black during 2008. Manager Donald Quigley keeps a close eye on broad economic trends. When the economy seems headed for a recession, he emphasizes Treasuries, which can hold their value during hard times. As the economy rebounds, he owns more corporate issues. Those can rally as corporate earnings improve and the risk of defaults decreases.
Artio currently has 23% of assets in foreign debt, including French government bonds. Quigley figures that the French bonds should do well because growth on the Continent will be slow. That will hold down interest rates. "The foreign bonds are a hedge that could protect us against rising rates in the U.S.," he says.